Paying the Piper

Would you purchase a car if the salesperson tried to close the deal by offering you the following incentive?: “I’ll sell it to you for $35,000 with low monthly payments, but if interest rates go up, we reserve the right to increase your payments regardless of your ability to pay.” Sounds unattractive and economically unsound, doesn’t it? Why would you do that to yourself?

Nonetheless, this is precisely the type of agreement that millions of homeowners throughout America and, by inference, some right here in Bridgewater entered into when they purchased homes, mortgaging them with what became known as “sub-prime” loans.

This began in the bygone heydays of abnormally low interests rates engineered by Alan Greenspan, the prior chairman of the Federal Reserve Board. He reduced rates to soften the economic downturn caused by the last stock market bubble, which he labeled as characterized by “irrational exuberance.”

Problem is, Mr. Greenspan got his timing wrong. He forgot to turn off the spigot which was pouring out a gusher of artificially low interest rates. Home builders, banks, and financiers aren’t stupid: They rushed in to fill the gap and stimulated a construction boom in the housing market. This resulted in the sale of homes to many naïve or unsuspecting consumers who temporarily benefited from low mortgage payments. Through the magic of sub-prime financing, these loans would rise to unaffordable levels when interest rates began their slow but inexorable climb back to normal. A real estate bubble was in the making.

The financial pages of newspapers and web sites are now full of fancy explanatory acronyms such as SIV, CDO, and other highfalutin terms to let you think that people knew what they were doing at the time and, “not-to-worry-thank-you, we are simply helping people pursue the American dream.”

Well, these structured investment vehicles and collateralized debt obligations are derivative securities far removed from the original mortgage loans and the homes which were intended to be their collateral. They were traded over and over again in a financial game of musical chairs. The game is over now, and many people are left sitting on the floor.

The problem is so bad that not even the big investment firms can readily move these securities, because no one knows precisely what their value is. The bottom has dropped out of the market. That’s why, as you are reading this, companies on Wall Street that specialize in valuing these types of financial instruments are frenetically working overtime, analyzing and setting prices on bundles of these SIV’s and CDO’s, whose plummeting worth is causing billions of dollars in write-offs to the suckers left holding them.

And what is the Federal Reserve’s response to this? Ben Bernanke, the newly-appointed chairman is lowering interest rates. Again!